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Today's Strong Sells

The biggest recommendation out there deserves the biggest sell rating.

There need to be more "sell" and "strong sell" ratings on stocks for the ratings to have any meaning. For the most part, if you look over how the Wall Street analyst community rates stocks, the ratings completely inhabit the narrow range of "neutral" to "strong buy."

Yet there are so many areas where a good "strong sell" rating would help investors immensely. The kind of help that might put, oh, about $40 billion or more annually into the pockets of investors.

Here's an example of a much-needed "strong sell" rating. There's a new study out (link opens PDF file) entitled "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry." It's the most detailed work ever conducted comparing the record of financial advisors to those who make their own mutual fund purchases.

Here are the results for returns for 1996 through 2002:

Financial advisors:

2.9%

Individual investors:

6.6%

Raw returns, net of all expenses. Includes bond and equity funds.

The study measured the results of trillions of dollars of mutual fund purchases, including the most well-known and trusted names in the industry. The study demonstrates that Wall Street's brokers do not find better-performing funds than individuals, do not allocate assets among different asset classes better than individuals, and do not display fewer biases toward the "hot" stock than individuals.

Every honest financial advisor needs to start issuing a "strong sell" rating to the world of managed mutual funds. But don't expect that to happen soon -- not with $40 billion (yes, that's billion) going to brokers and mutual fund managers every year from sales fees and management costs.

Where's the strong buy?To the extent that mutual funds have any true benefits, they can provide investors with a diversified portfolio. But you can create that diversification directly by owning the same stocks that mutual funds own, at a fraction of the annual cost.

To begin to get the right diversification, become aware of the major divisions of stocks, as defined by the Global Industry Classification Standards (GICS):

Energy

Materials

Industrials

Consumer discretionary

Consumer staples

Health care

Financials

Information technology

Telecommunication services

Utilities

A portfolio with the greatest possible diversification benefits can be built by owning about two companies from each of these classifications. Here's an example. I've selected companies with low-ish price-to-earnings ratios (P/Es) and high-ish returns on equity (ROE) relative to the industry averages. That combination of factors has historically produced better-than-average returns:

GICS

Company

P/E

ROE

Energy

Valero (NYSE: VLO)

7

24%

Materials

Nucor (NYSE: NUE)

13

30%

Industrials

Actuant

16

23%

Consumer Discretionary

Disney (NYSE: DIS)

16

14%

Consumer Staples

Church & Dwight (NYSE: CHD)

22

17%

Health Care

Universal Health Services (NYSE: UHS)

17

11%

Financials

Bank of America

12

11%

Information Technology

Satyam Computer (NYSE: SAY)

21

26%

Telecom

America Movil (NYSE: AMX)

20

49%

Utilities

Energen

14

24%

*Data from Capital IQ.

There's a lot more to learn about companies than their P/Es and ROEs. A more in-depth understanding of companies will give you a chance to not only equal the market's returns (which you have virtually no chance of doing with managed mutual funds), but surpass them. At Motley Fool Stock Advisor, we have a five-year track record of beating the market with our recommendations; more importantly, we educate our members about how to do so on their own. If you'd like to try out the service with a totally free 30-day pass, be our guest.

This article was originally published Feb. 2, 2007. It has been updated.